Javier G. Vande Steeg, President of Asset Preservation, Inc. (API) interviewed Low Weller, J.D. Partner at Weller Partners LLP, and discussed highlights of the recently released Section 1031 Real Property Treasury Regulations.
Mr. Vande Steeg: Lou, I know you have been involved at a high level in the development of the final “real property” regulations, can you tell us a little history regarding the passage of the new regulations?
Mr. Weller: When the 2017 Tax Cuts and Jobs Act (TCJA) bill changed Section 1031 to apply only to real property, the issue of what is “real property” for this section became more central than when that issue only affected whether something was “like-kind.” The Regulations under Section 1031 had never defined real property before, but had addressed what real property was like kind: examples being the familiar rules that improved real property is like-kind to unimproved real property and that a tenant interest in a lease of real property with a term of more than 30 years is like-kind to a fee interest in real property.
Since there is now a bright-line test between real property and everything else in terms of qualifying for Section 1031 deferral treatment the IRS decided some clarity was needed and embarked on the Regulations project.
They also decided to solve a problem that had come up in the wake of the TCJA in deferred exchanges due to the new restriction. Where money from the sale of relinquished real property was used to buy replacement property that consisted of both real property and personal property, advisors got concerned that the qualified intermediary safe harbor from constructive receipt could be compromised if a QI utilized real property proceeds to buy non real estate assets. Since many real estate transactions involve the purchase of non-real estate personal property (i.e. a hotel purchase also involving lots of furniture), these advisors sought a safe harbor allowing the use of relinquished real property proceeds to buy non real estate property assets as long as the predominant use was to buy real estate. That’s the genesis of the “incidental property” element of the final regulations.
Mr. Vande Steeg: In your opinion, what are the highlights for the average real estate investors and their advisors?
Mr. Weller: I call the approach that was ultimately adopted “State Law Plus” and endorse it. State law definitions of real property have historically been the key element in determining what is real property for Section 1031 purposes. However, in 2012 the IRS issued a Chief Counsel Advice that took issue with this and asserted that a separate federal standard should apply and that state law didn’t govern the definition. When initially released as proposed regulations, that’s the approach IRS took. I, and a number of others, objected to this as being contrary to Congress’ clear directive in TCJA not to change the definition of what was or was not real property for Section 1031. Fortunately, the IRS and Treasury listened to the public comments and also spoke to some of us who work in the area and ultimately decided to abandon the initial position. The final regulations ratify the primacy of state law and eliminate any test looking at the function of something that is real property for state law – which had been reflected in the proposed regulations as a concept where real property fixtures that produced goods or services would not be real property for Section 1031. I called this the “machinery exclusion” and it was dropped from the final regulations.
Another critical highlight included in the final regulations is the clear confirmation that the definition of real property for Section 1031 purposes is separate and apart from the definition of real property for other Internal Revenue Code purposes, such as depreciation, REIT qualification, foreign investor withholding, or capitalization versus deduction analysis. This is particularly important in relation to cost segregation studies, as it is now clear that classifying something as eligible for five- or seven-year cost recovery (or even immediate write off under bonus depreciation rules) does not mean that the asset is not real property for Section 1031. However, investors should remember that these classifications do have consequences when assets are sold since the depreciation recapture rules of Code Sections 1245 and 1250 can override Section 1031 deferral.
Another thing to watch for is the newly expanded definition of some intangible assets relating to real estate as real property for Section 1031. Options to purchase are specifically included in this. What we don’t yet know is how to analyze options of limited duration under the “like-kind” standard. For example, even though an option to buy real estate is considered real property, it is not clear if an option with a five-year duration will be like-kind to a fee interest or even to an option with a different duration.
Mr. Vande Steeg: Do you see any areas that were not sufficiently addressed? Are there still some open-ended issues?
Mr. Weller: Yes, there remain a number of open issues. Some have commented on the issues of debt allocation in exchanges of multiple assets now that only real property qualifies. We still do not have regulations covering a number of issues arising from the related party exchange rules of Code Section 1031(f) and (g). We still lack rules dealing with deferred exchange aspects of tenancy in common structures. We are waiting to see what the IRS does with “non safe-harbor” reverse exchanges in light of the fact that it declined to acquiesce to the Tax Court Bartell case on this topic. Most of these issues have been around for some time, and following the final regulations release, many of us who work in this area aren’t holding our breath for anything further coming out soon, given limited IRS resources and other projects to which they must give attention as tax law evolves.